Category Archives: Emerging Markets

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If You’re Thinking About Global Diversification, You Should Read This


  • The developed world is depending, and will continue to depend, more and more on the developing world.
  • The focus of productivity and GDP growth is in Asia.
  • The U.S. is the only country with trade deficits since 1976.

Introduction

Nobody knows where the market will go in the next week, month, or year, but what can give investors an edge is to look at macro trends that are bound to influence economies and returns on investments.

In this article we are going to analyze productivity and trade balances among the most important global economic powers, and try to derive a long term trend from it in order to improve the international exposure in our portfolios.

Productivity

Productivity is essential for economic development in the long term, and in the short term is only beaten by credit. But as credit has its cycles in the long term, productivity is what determines if a country is a success or not because credit can only be used up to a point. Productivity is the mechanism through which societies progress.

The issue with productivity is that it is stuck globally. This is because productivity is falling in the U.S. and Japan, slowing down in China, and countries like India still don’t manage to compensate for the declines of these superpowers. However, the trend is clear.

figure 1 productivity
Figure 1: Labor productivity growth rates. Source: Conference Board.

The trend shows how the largest global productivity and GDP growth comes from Asia with some bright spots in Africa. As Africa is still undiscovered as an investment opportunity and complicated to invest in, it is good to focus on Asia for international long term diversification.

Higher productivity means that people are achieving more with their own means, education and capital, which improves economics and living standards. This further improves education and healthcare which creates an upward spiral. As Asian countries have a low baseline, there is plenty of room and time for them to develop and grow.

Jim Rogers, co-founder of the famous Quantum Fund with George Soros, is heavily invested in Vietnam. Of course, such an investment is difficult to make as it has many capital constraints at the moment, but it shows you where smart money is going.

A country that is easier to invest in is India, which had a GDP growth rate of 7.3% and productivity growth of 5.2% in 2015. The fact that productivity growth in the U.S. was 0.7% in 2015 and GDP growth was at 2.4% means that GDP growth isn’t exclusively influenced by long term, healthy productivity increases, as is the case in India, but is also greatly influenced by debt. We all know that debt works in cycles, so sooner or later we will see some deleveraging take place that will send the U.S. into a recession, hopefully later than sooner so that we can still enjoy this bull market for a while longer. The situation is the same in Europe; productivity grew at 0.9% while GDP grew at 2.0% in 2015.

Balance of Trade

Among other factors like productivity and credit cycles, the balance of trade (BOT) is a very important factor for assessing the health of an economy. The BOT is often shunned by economist as one country has had a BOT deficit for 41 years and things seem to still go pretty well there. We are of course talking about the U.S. which saw its last trade surplus in 1976.

figure 2 U.s. balance of trade
Figure 2: U.S. BOT. Source: Trading Economics.

This means one thing: the U.S. is spending more than it is producing which is not news, but is good to have in mind when deciding where to go with your global investments.

Other countries—like the U.K., Canada and Brazil—also have BOT deficits, but they have evened out in the long term with past surpluses, with things being a little bit worse for the U.K.

figure 3 canada
Figure 3: Canada BOT. Source: Trading Economics.

Europe, China and Japan have a surplus in their trade balances.

figure 4 EU balance of trade
Figure 4: Europe BOT. Source: Trading Economics.

BOTs show only one side of the equation where usually net investments cover for the trade deficit. But the current account for the U.S. is also negative.

figure 5 current account
Figure 5: U.S. current account. Source: Trading Economics.

Conclusion

The world will be a very different place in 20 years as global trade, productivity and economic growth shifts from the western world toward Asia. With countries like India and Indonesia reminding us of what China was 20 years ago, we should not be surprised if such a scenario replicates itself in those and other emerging countries.

This doesn’t mean that we should be completely invested in emerging markets, but if we have to choose between a company that has sales only in the U.S. and a company that is selling globally for the same valuation, we ought to go for the global one as global macroeconomic long term trends are clear and unavoidable.

The good news is that emerging markets growth is what will push the currently stuck developed economies forward as increases in global demand will be good for everyone.

 

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The Future Will Blow Your Mind. How Can You Take Advantage Of It?


  • Global GDP has quadrupled in the last 35 years and will probably do so again in the next 35 years.
  • By 2050 it’s expected there will be 10 billion people on earth and most of them will be living a western lifestyle.
  • While the forecasts are pretty certain, the issue is that the way towards those forecasts will not be linear. Investors should be careful not to get excited and jump into bubbles.

Introduction 

Investing is both complicated and simple at the same time. Today we are going to show the simple side of investing by analyzing a few factors that are almost certain and that will have a huge influence on your investing returns. By analyzing a few global demographic and economic trends we can see where the world will be in the future and connect that with our investments pictures, a scenario that is actually mind-blowing. Keep reading…

Global Population & Economic Development

A number that is essential for investors is the following:

figure 1 global population
Source: Worldometers.

 

What is even more important is that the population is growing and will continue to grow. Global population is expected to reach 9.7 billion by 2050. The biggest expected growth is in Africa, followed by Oceania, the Americas and Asia.

figure 2 global population forecast
Figure 2: The World’s population. Source: The Economist.

 

This simply means that the global market for companies and global demand will be at least 31% larger in 34 years. On top of the increase in the global population, the economic structure and growth forecasts for the majority of the global population are astonishing.

The list below shows the current top 15 countries by population and their respective GDP per capita.

figure 3 data
Figure 3: Population and GDP per capita. Source: Worldometers, World Bank.

 

Of the 15 most populous countries, only the U.S. and Japan have a GDP per capita higher than $10,000. Countries like Indonesia, with 260 million people, have to grow 10 fold to reach the Japanese standard while India has to grow 20 fold. Thankfully, all of these currently underdeveloped countries are growing at amazing rates.

figure 4 global gdp growth
Figure 4: Global GDP growth. Source: The Economist.

 

If we look at where the global GDP per capita average was 35 years ago we can only imagine where the GDP will be in 35 years with the explosive growth in emerging markets.

figure 5 glboal GDP per capita
Figure 5: Global GDP per capital in current US$. Source: World Bank.

 

If GDP per capital quadruples in the next 35 years like it did in the last 35 years, in 2050 we will have an average global GDP per capita of $40,000, which is higher than what Japan currently has.

A higher GDP will make many things available that are currently unavailable. Many people will want a car and we can only imagine what will that do for the car industry. Of the 15 countries mentioned above, only the U.S. and Japan have reached a level of car per capita saturation.

figure 6 cars per capita
Figure 6: Global cars per capita. Source: Charts Bin.

 

Cars, homes, infrastructure, software, hardware, travel, fashion, medicine, food and who knows how many more things that we can’t even imagine at the moment will be a normal in 2050 for the majority of the global population.

How sure can we be that this will become a reality in the next 35 years? Facebook gives us a clue. Their data shows the fastest growth rates in the Rest of the World and Asia which means that people there are more and more informed about a western lifestyle which will encourage them to seek such a life.

figure 7 daily users
Figure 7: Facebook’s global growth in daily active users. Source: Facebook.

 

We can clearly conclude that the world will be a much different place in 35 years, especially when we look at how different the world is now compared to how it was 35 years ago. Just to gather the data I’ve listed above would have taken me a year or longer to gather 35 years ago, while today I can go online and have everything in front of me in an instant. Globalization, a larger population and inevitable economic development are the trends that will undoubtedly influence your investments in the next 35 years.

What Investors Should Do

If you’re in it for the long-term, you have nothing to worry about especially if you are well diversified and have made smart investments. What do we mean by smart investments? The global growth discussed above is pretty certain, but what is uncertain is the linearity of it. Going back to figure 5 we can see that from 1995 to 2002 there was very little improvement in global GDP.  Only after 2002 did it explode. This means that the road to quadrupling global GDP will not be smooth.

An investor has to be careful not to overpay for an investment. Many people see the above numbers and get very excited. This is what creates bubbles. As we will have many recessions in the next 35 years, it is wise not to get too excited about the numbers above but to invest at maximum pessimism. Currently there is excitement about healthcare, social networks, and consumer discretionary, and negativism in agriculture, food, energy, mining and shipping. With the growth described above, there is more certainty that demand will grow for commodities than for social networks which is a perfect example of how investors get carried away.

Charlie Munger, Buffett’s investment partner, continually restates that investing should be like watching paint dry and that if you want excitement, take $800 bucks and go to the casino. All the inevitable economic and demographic developments are pretty certain, but will slowly grow into the forecasted numbers. If your investment horizon is long you can afford to be invested in the sectors that will surely benefit from the structural trends and wait for the booms. What you should avoid is to be invested in bubbles because those are the destroyers of long-term returns.

For more specific information about a sector that we believe has just reached a point of maximum pessimism and is trading dirt cheap, but is sure to benefit from the massive future growth in global GDP, click here.

 

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The U.S. Dollar: Should You Stick To It Or Diversify Now?


  • The dollar has been positively correlated with stocks for the last 4 years which is unusual.
  • Potential FED interest rate increases don’t make international diversification a great idea right now.
  • Any sign of a U.S. recession should be a good time to think about international diversification with emerging markets.

Introduction

On big news sites like Bloomberg you often come across headlines related to the movement of the U.S. dollar. The headline below is a good example.

figure 1 bloomberg news

Such headlines relay what has been going on in the few hours before publication but are completely irrelevant for investors that aren’t trading pips on forex. This article is going to investigate the longer term relationship between the dollar and stocks, and discuss the best option for maximum return with minimal risk.

Recent Dollar & Stocks Movements

Before 2012, as the dollar strengthened, stocks went down and vice versa. The reason was simple, a strong dollar meant U.S. exports were less competitive and businesses suffered, while a weak dollar made U.S. goods cheaper across the world and increased corporate earnings. Since 2012, however, the story has been a little bit different. The dollar has gotten stronger and stocks have gone higher.

figure 2 fred dollar stocks
Figure 2: U.S. dollar vs. S&P 500. Source: FRED.

The reason behind this is the fact that no matter what we think of the FED, it is the most globally coherent financial institution. In an environment where the European central bank is continuing with stimulus and the Japanese think about printing money for direct spending, the FED is the only institution that contemplates raising interest rates. So the positive correlation between the U.S. dollar and the S&P 500 comes from the relative success of the U.S. economy and the global faith in the U.S. dollar as the only safe currency.

On one hand, the strong dollar lowers corporate revenue. But on the other hand, it also lowers corporate costs, something CEOs never talk about when reporting earnings. As the U.S. has a net trade deficit, the strong U.S. dollar makes everything around the world cheaper and therefore expenses should also be much lower. Don’t forget this in the next earnings season.

Long Term Dollar Strength

The long term perspective is a little bit different than the above. Since 1975, the dollar has slowly but consistently weakened in relation to foreign currencies.

figure 3 long term dollar
Figure 3: Dollar index since 1975. Source: FRED.

The slow decline of the dollar means that global trends are shifting, which is also normal given the development in China and other countries. As the rest of the world is expected to grow at a faster rate than the U.S., the long term trend for the dollar is clearly and slowly downwards. This point is essential for international diversification. We have discussed many times how ChinaIndia and other fast growing emerging markets are essential for healthy diversification.

Forecasts & Economic Factors

In the short to medium term, it looks like the dollar is going to continue to strengthen. If the FED increases interest rates and others continue with their stimulus, the dollar will surge even higher. The most recent FOMC minutes clearly indicate that we could see a rate hike by the end of the year. But, eventually the strength of the dollar will kick back as exports will be more expensive and the trend will turn and continue to follow the declining line seen in figure 3 above.

What To Do

There are two options with currencies. They go up or down and do so for longer periods until the structural influences rebalance on a global scale. With interest rates low and good news from the U.S. economy, the FED will eventually raise interest rates and send the dollar higher. The moment of maximum strength of the U.S. economy and the dollar will be the time to diversify to other currencies but until then, sticking to the dollar is not a bad idea, especially for the majority of our readers who are living in the U.S. If the U.S. economy slows down and the dollar weakens, you will still have most of your assets in your home currency which will not represent a real change to your portfolio. But if you are exposed to other currencies and the dollar gets stronger, you will have to look at losses, which is never pretty.

Conclusion

U.S. investors have the benefit that if the dollar gets weaker, international diversification is just a missed opportunity while if the dollar gets stronger, it was a good idea to stay at home. International investors have to play it differently. With the FED eventually increasing rates, the dollar has no other direction to go than up which is a great diversification play when looking at the stimulus in Europe and Japan which weakens their currencies.

In the long term, it pays to be exposed to the currencies of the countries that are going to grow at a faster pace than the U.S. economy, i.e. emerging markets. We have seen the Chinese Yuan get weaker in the past two years due to some fears about China slowing down, but the longer term trend is clear.

figure 4 cny usd
Figure 4: Chinese Yuan per 1 USD. Source: XE.

With the economy expected to grow at a pace of above 6% in the next 10 years and the Chinese getting richer, there is only one way for their currency, up. Think about international diversification, but only when the dollar strength reaches its structural limits and the U.S. is close to a recession.

 

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Emerging Markets Are Hot – Here Is Where You Should Put Your Money


  • Emerging markets are up 10% since our last article on the subject, but the FED’s rate action might quickly erase the gains.
  • Valuations are starting to diverge, but don’t fight the trend.
  • Keep an eye on China as it is relatively undervalued and still boosts economic growth of 6.7%.

Introduction

In May we discussed how emerging markets have been rediscovered but are still undervalued. Since then, the emerging markets ETF is up 10%.

figure 1 emerging markets
Figure 1: iShares MSCI Emerging Markets ETF (EEM) since May. Source: iShares.

As emerging markets include a lot of countries and segments, in this article we are going to see which segments in emerging markets are the best investments and which hold the highest risks.

What Has Been Going On?

The central reason emerging markets have outperformed is because investors regained confidence in them and plowed more capital into them, unlike in 2015 when the story was the opposite. The fact that developed countries continue with their monetary easing increases risk appetite and forces investors to search for better returns in riskier assets such as emerging markets. This partly explains why emerging markets asset prices have been pushed higher.

Not only do stocks enjoy the benefit of global monetary easing, but so do bonds. As emerging markets have higher yields, desperate investors pursue those yields no matter the risks. But this is a common trap in which many investors have been caught in the past. Think of Argentina. This is a typical textbook situation, when yields are high and increasing, people pull their money out of emerging markets in fear that things might get worse. But when yields are falling, and it is unlikely that things will get better, people plow money into emerging markets. The emerging markets premium in comparison to U.S. junk bonds is minimal, but let’s not forget that by holding emerging market debt you are often exposed to currency risks.

figure 2 bond yields
Figure 2: Difference between yields on emerging markets and U.S. junk bonds. Source: Bloomberg.

Such a low premium suggest that investors should carefully assess the risks before investing in emerging markets at these low yields. But what is pushing emerging markets up is the opposite of what pushed them down in 2015, capital inflows and outflows. Since the beginning of 2016, capital inflows have been increasing.

figure 3 flows
Figure 3: Total non-resident capital inflows to emerging markets. Source: Institute of International Finance.

With increased capital inflows, asset prices are bound to go up, but not all emerging markets are enjoying the same investor confidence. China is a good example. Global funds toward China are negative as investors fear the further depreciation of the yuan and slower economic growth.

Fundamental Perspective

From a valuation perspective, emerging markets are still undervalued despite the recent upside. The iShares MSCI Emerging Markets ETF (EEM) has a PE ratio of 11.56 and a price-to-book value of 1.56 which is still far from the iShares S&P 500 ETF (IVV) PE ratio of 20.7 and price-to-book value of 2.88. Chinese stocks are the cheapest with a PE ratio of just 8.24 and a price-to-book value of 1.41 for the iShares MSCI China ETF (MCHI).

figure 4 emerging markets funds
Figure 3: Emerging markets funds. Source: Wall Street Journal.

As our primary investment thesis back in May was that emerging markets are undervalued, the current price increase and investor unwillingness to invest in China make it the probable future winner. To know more about recent developments in China read our recent article on it here.

As global emerging markets are in an uptrend and far from fair valuations, it might be premature to completely jump exclusively into China and ignore other emerging markets. However, as valuations in other emerging markets continue to increase, creating an even larger divergence from China, it might make sense to “overweight” your portfolio toward China, since in the long term earnings are all that matter.

As a point of reference, the Brazil ETF (EWZ) PE ratio is 13.29 while the Indian ETF (INDA) PE ratio is higher at 21.15. Compared to a PE ratio of 8.24 for China.  More daring investors might want to look at Russia where the situation has stabilized but still has low valuations with a PE ratio of 7.36 and a price-to-book ratio of 0.76 for the iShares Russian ETF (ERUS). We’ll discuss more about Russia in a future Investiv Daily article.

For specific investments, the “detailed holdings and analytics” document on the iShares ETFs’ page is a great resource.

Risks

When investing in emerging markets, don’t forget about risk. Drops are sudden and sharp, especially around high valuations and low yields. For example, the iShares China ETF (MCHI) is still 28.5% below its 2015 high.

figure 5 china ETF
Figure 4: China ETF. Source: iShares.

The moral of the story is to always look at valuations and don’t get euphoric about emerging markets. Boom and bust cycles are much more frequent than with developed markets due to lower market capitalizations that are strongly influenced by global capital flows which are fickle. We have witnessed two sharp emerging markets declines in the last 12 months—one in August 2015 and the second in January—both of which are a good reminder to not forget that volatility is on the daily menu and another downturn might be just around the corner.

The Fed poses an additional risk to emerging markets if it decides to increase rates due to the tightening U.S. labor market in order to stay ahead of the curve. Higher interest rates in the U.S. would quickly shift capital flows to the less risky U.S. from the riskier emerging markets.

Conclusion

Emerging market are and will stay difficult to navigate. Their volatility is based on low market capitalizations that can easily be influenced with relatively low capital flows when compared to developed markets. Therefore, a good idea is to watch them carefully and not fight the trend because emerging markets tend to move fast in various directions. In January 2016, it seemed like the end of emerging markets was near and now, just 8 months later, it seems all roses.

For investors not exposed to emerging markets, the best thing to do is to look at specific assets that have consistent cash flows and provide diversification. Diversification can also be found in individual companies that have revenues both in the developed world and emerging markets.

Chinese companies have relatively low PE ratios as investors are still not confident about the Chinese economy. Beware that we are not talking here about a recession, but only about growth worries related to China managing to continue growing at more than 6.7% a year.

Stay tuned to Investiv Daily for market updates and specific investment reports on emerging market stocks.

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BREXIT Aftermath: Where to Look for Returns & What to Avoid Now


  • The U.S. and Europe are overvalued, especially seeing the current political situation and economic fragility.
  • What’s about to hit Europe and the U.S. already hit emerging markets in 2015. There are opportunities in emerging markets now, but where?
  • Bonds seem the riskiest asset of all with no yield and huge potential downside.

Introduction

After last week’s BREXIT vote the markets have been in a free fall with a slight recovery yesterday. But savvy investors have been expecting this and it has been a recurring theme at Investiv Daily that stocks are overvalued. In such an overvalued environment it is normal that inflated asset prices take a beating at any sign of future uncertainty.

As one’s misfortune is another’s fortune, this article is going to elaborate on what to look for and what to avoid in order to limit risks and maximize returns.

The U.S. Stock Market

The U.S. stock market is fully valued and therefore the decline should not have come as a surprise. The S&P 500 has been moving sideways for the last year and a half and many are expecting a recession. In such an environment the risks are high and the potential returns very low.

figure 1 pe earnings
Figure 1: S&P 500 PE ratio and earnings. Source: Multpl.

With a PE ratio of 24 and declining earnings, the only way for investors to realize capital gains by investing in the S&P 500 would be through the formation of an asset bubble. With the current political turmoil, slower U.S. productivity, lower employment participation and strong dollar, this seems like a very unlikely scenario.

On the other hand, those factors might start a recession that could easily lower the S&P 500 to the average historical PE ratio of 15 which would cause a 1,300 point, or 35% drop. Therefore, the conclusion is that the S&P 500 carries a lot of risks with limited upside.

Emerging Markets

Emerging markets were the thing to avoid in 2015, but they still possess long term factors that should make them the long term investment winners, especially if bought at these depressed prices. Let us focus on Brazil as an example.

Brazil was hit by various corruption scandals and by the deepest recession in the last two decades. But, Brazil is still a young country rich in natural resources and on the road to becoming part of the developed world, minor setbacks are normal and should be used as an investment opportunity.

figure 2 brazil GDP
Figure 2: Brazil’s GDP in billions of US dollars. Source: Trading Economics.

Brazil’s GDP grew from $1,107 billion to $2,346 billion in ten years which still represents a yearly average growth of 7.7%. As the market has already factored in the chance of a Brazil bankruptcy, the risks and rewards of investing there are opposite from what they are in the U.S., as there is no risk of a U.S. bankruptcy.

Brazil’s current CAPE (Cyclically adjusted 10 year average price earnings ratio) is currently 3 times undervalued at 8.2, while the S&P 500 has a CAPE ratio of 24.6. The undervaluation is probably the reason why Brazilian stocks have behaved very well in the last few days. The Brazilian stock index is still in positive territory for the month and year to date. On top of the relative stability, U.S. investors could also gain from currency benefits as the oversold real is slowly returning to its real exchange value toward the dollar.

figure 3 usd brl
Figure 3: USD vs BRL in the last year. Source: XE.

To conclude, Brazil represents a young, resource rich country where it seems that all that could go wrong did go wrong last year. More positive news than negative news should now be expected. On top of that, it is one of the most undervalued markets in the world.

Europe

The situation in Europe is similar if not worse than the one in the U.S. To put it simply, the markets are in an asset bubble as the European Central Bank has been issuing huge amounts of liquidity with the hope of faster economic growth and some inflation. It succeeded for a while but the BREXIT issue will for sure have a negative impact on current economic growth when coupled with the overvalued markets, the risks outweigh the rewards.

The average PE ratio in Italy is 31.5, Netherlands 28.5, United Kingdom 35.4 and Germany 19. There is also the euro issue where any political turmoil could weaken the euro and lower investment returns for U.S. investors.

Europe should be avoided until asset prices reflect the real state of the economy and the political situation, thus far below current prices, at least 50%.

Gold and Bonds

It is uncommon to put gold and bonds in the same basket but as they both have practically no yield with negative interest rates on the most secure government bonds, it seems the right choice.

Gold is currently at its year high as investors look for safety. The problem with gold is that it has no yield and most investors come too late to the party as gold primarily appreciates at maximum turmoil as it has done in the past few days.

figure 4 gold prices
Figure 4: Gold prices in the last year. Source: Bloomberg.

If political turmoil persists and inflation arrives due to the high liquidity, gold might be the winner, but any signs of stabilization would negatively affect gold. It can be concluded that gold represents a good hedge and could be a part of a well-diversified portfolio. Investors that seek a riskier investment than gold itself could go for gold mining stocks that offer a dividend yield and potential growth, though gold mining stocks also come with much more volatility.

As for government bonds, the risks seem to outweigh the rewards. Yes, it is possible to make capital gains if interest rates further decline, but this defies logic as there is no point in holding negative yielding bonds. On the other hand, if yields increase bonds could fall tremendously as a 100% increase in bond yields should consequently lower bond prices by 50%. Therefore, the current situation with bonds isn’t what’s typically assumed about bonds—low risk with high rewards—as right now they are high risk with low rewards.

Conclusion

At this point, after a 7-year bull market and high liquidity provided by central banks, investors should be wary of being overweight in the same things that were good 7 years ago. Many analysts have forgotten how to analyze risk as we have not seen a bear market since 2009, but this is exactly the time when one should look at risks before rewards. High asset prices and low yields mean that investors do not see much risk and are willing to pay hefty prices, but this is exactly the kind of situation that can bring lots of investment pains.

Any signs of recession, the continuation of the decline in corporate earnings, and a shift from the current investor’s perception that central banks are still able to save the markets with additional intervention, could easily send the stock market down by 30%. Assess your risks, estimate the rewards, and position your portfolio accordingly.

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How to Prepare Your Portfolio For The Next Recession or Stock Market Crash


  • The risks of a slowdown are higher than the upside.
  • Fundamental trends are negative in advanced economies while emerging markets show higher growth rates and are cheaper.
  • It is important to create a diversified portfolio with uncorrelated assets.

Introduction

In an environment where it seems maximum potential for the U.S. economy has been reached, the St. Louis FED chief, James Bullard, has said in his most recent report that he favors only one interest rate increase through 2018, which would at best keep things stable. His view is further supported by the fact that the unemployment rate is sitting at below 5%, and the Personal Consumption Expenditures PCE inflation—measured by the Dallas FED—is at 1.84%, both of which signal that the economy has reached its maximum potential.

1 figure trimmed inflation
Figure 1: Trimmed mean PCE inflation. Source: FRED.

The scary part of the report is where Mr. Bullard describes how forecasts are made based on the current situation, which will most definitely change. What is difficult to predict is the direction of the change therefore, forecasts are bound to be incorrect and under the influence of various risks like a return to the normal Phillips curve influence where low unemployment triggers inflation, or a recession even if no current data indicates the possibility of one. Thus only an extremely positive scenario would trigger interest rate increases if fundamentals like inflation or productivity stay stable.

2 figure fed stlouis
Figure 2: St. Louis FED’s U.S. macroeconomic outlook. Source: St. Louis FED.

The conclusion is that practically anything can happen, and the FED has absolutely no idea as to where the economy will be in a year or two. Even FED Chairwoman Yellen admits that the 2013 expected interest rates of 4% for 2016 were too high and that an aging society and a slump in productivity growth will keep the subdued economic indicators persistent.

In such an uncertain environment, an investor should look at the best ways to protect his downside and maximize his upside.

Investment Ideas

Let us start with bonds where interest rates have been declining since the start of this century.

Bonds

3 figure bonds
Figure 3: 10-year government bonds yields. Source: Wall Street Journal.

As bond prices are inverse to bond yields, any increase in yields would precipitate bond prices, thus bonds are currently low yield and high risk. Usually considered safe havens in recession times, bonds currently do not provide such protection as it is better to keep cash than bonds with negative interest rates. There is the option of further bond price increases, but that is a highly unlikely scenario as bond yields are at historical lows.

The Stock Market

The S&P 500 is still holding well, but does not manage to break the previous highs despite having come close several times.

4 figure s&P 500
Figure 4: S&P 500 in the last 12 months. Source: Bloomberg.

The S&P 500 dividend yield is 2.12% which might look tempting when compared to the extremely low bond yields, but it is meagre when compared to the historical mean of 4.39%. A return to the mean would result in a drop of 50% or more of the S&P 500 index. The conclusion here is the same as with bonds: High risk, low returns.

But there is an option with stocks that should limit the downside. Dividend stocks that will not see their cash flows affected by a slowing down in the economy are always assets toward which investors run when trouble comes. Examples can be found in telecommunication, consumer staples and healthcare.

Emerging Markets

If the reason for economic stagnation in the developed world is an aging society, slow productivity growth and emerging markets competition, a contrarian thesis would be to invest into emerging markets.

Emerging markets have a relatively young population and are currently shunned by investors as too risky amidst a commodity price slump. But no matter the current issues, the World Bank expects emerging markets and developing economies to grow at rates north of 4% in the long term, while advanced economies are expected to grow below 2%.

Currently, advanced economies are preferred by investors as they regard them as secure, but long term structural trends are strong in place even if we do not choose to see them. What China has done in the last 15 years could be the same as India is about to do. Brazil will probably also return to growth someday.

The following figure will show that the current developed world impression of asset security is mostly funded by debt which is unsustainable in the long term.

figure 5 investment position
Figure 5: U.S. net international investment position. Source: Bureau of Economic Analysis.

On top of that, emerging markets are much cheaper than developed ones according to the Cyclically Adjusted Price Earnings (CAPE) ratio which takes into account earnings from the past 10 years.

figure 6 global cape
Figure 6: Global CAPE map. Source: Star Capital.

For long term investors, the less risky option might be to dig for good investments in emerging markets with positive demographics and a strong growth outlook. Currently those investments are out of favor, but this is exactly the environment where investments give the best returns.

Gold

Gold is a doomsday investment, it protects you against inflation and is the metal that surges in difficult times. Typically as the economy does well, stocks grow and gold declines because gold has no yield. The opposite happens in turmoil.

7 figure guardian precious metals
Figure 7: Gold and stocks cycle. Source: Guardian Precious Metals.

You can invest in gold by buying it physically, through ETFs or by buying gold miner stocks.

Conclusion

As always, good diversification should provide sufficient downside protection but a portfolio has to be diversified with uncorrelated assets.

If you have Ford in your portfolio and then you add some Caterpillar, that is not real diversification. Gold, emerging markets, cash, and quality stocks should enable a portfolio to weather economic hardships.

Don’t forget that after every recession comes a recovery, so be ready to increase your exposure to stocks when assets are cheap, even if everyone will be thinking that there is no tomorrow.

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Emerging Markets – Time to Buy?


  • Emerging markets have rebounded but are still neglected.
  • Their fundamentals are way better than those of the S&P 500.
  • Volatility and currency risks are omnipresent but a good strategy can increase returns in such an environment.

Introduction

Only positive news comes from the US economy, from housing growth to the Federal Reserve Chairwoman Janet Yellen signaling a rate hike. All this news is pushing the S&P 500 towards reaching new highs. Yet a stronger dollar in the longer term will mean cheaper imports and more expensive exports. This perspective inevitably leads toward contemplating investing into emerging markets as they are currently shunned by the investment community due to their relative underperformance and slump in commodity prices. But, going by the maxim that the best returns are made by going where no one wants to go, this article is going to provide analysis on emerging market opportunities.

Current Situation in Emerging Markets

According to Bloomberg, global investors pulled $735 billion out of emerging markets with China accounting for 90% of it. This resulted in a sharp decline in the iShares MSCI Emerging Markets ETF that tracks the MSCI emerging markets index which fell by almost 20% in the last 12 months, but was also down 31% in January.

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Figure 1: iShares MSCI emerging markets ET last 12 months. Source: iShares.

The MSCI emerging markets ETF consist of 23 countries representing 10% of global market capitalization with the greatest weights attributed to China (23.89%), South Korea (15.29%), Taiwan (12.18%), India (8.1%), Brazil (6.58%) and Russia (3.75%). The PE ratio of the iShares MSCI Emerging Markets ETF is 11.44, the price to book value is 1.4 and the current distribution yield is 3.17%. Emerging markets have a PE ratio that is only 47% of the S&P 500 PE ratio, the price to book ratio is only 49% and dividend yield is 1.5 times higher than the S&P 500. As 23% of the S&P 500 revenues are generated in emerging markets, it seems logical to buy exposure to emerging markets directly at a much lower valuation.

This cheapness and decline in emerging markets was mostly caused by weaker currencies in relation to the dollar, less available capital due to the discontinuation of the US quantitative easing and low commodity prices. With low commodity prices, countries that are rich with natural resources like Brazil or Russia find it difficult be liquid which further ignites a spiral of downgrades and capital outflows.

Risks Related to Emerging Markets

The situation is bad; can it get worse?

The answer is simple: yes. Further increases in US interest rates will create a stronger dollar with higher yields and more money could be pulled out of emerging markets. A stronger dollar lowers global commodity prices and emerging countries have less liquidity on which to count on, especially as many have bigger parts of their debt in foreign currencies.

Weak commodity markets also push down capital inflows and further destabilize emerging economies. It is impossible to exactly catch the bottom or to know if the current pull back is just a temporary one or the start of a long term trend, so the best way to approach emerging markets is to weight one’s exposure to them. There are several reasons why emerging markets portfolio exposure should be beneficial.

Reasons to be Exposed to Emerging Markets

The January 2016 International Monetary Fund outlook forecasts global GDP growth at 3.4% for 2016 where developed economies are expected to grow at 2.1%, while emerging markets are expected to grow at 4.3% despite the above mentioned difficulties. Asia is expected to be the leader in growth with 6.3%, while Latin America and Russia are expected to contract in 2016 and rebound only in 2017. South America and Russia drag emerging markets down, but from an investing perspective the best time to invest is when times are difficult.

The already mentioned lower valuations should provide excellent diversification to your portfolio, albeit a volatile one. Also, any weakness in the US and the dollar would quickly reignite interest for emerging markets and make those interest rates more attractive, thus pushing emerging currencies higher.

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Figure 2: Emerging markets interest rates are high. Source: Trading Economics.

The US interest rate of 0.5% seems really low when compared to emerging markets, therefore exposure to other countries should provide good long term diversification. The volatility of emerging markets is bad when they fall, but could be an extraordinary tailwind if they rebound.

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Figure 3: iShares emerging ETF vs the S&P 500. Source: Yahoo Finance.

Any pickup in emerging markets economies, or a more positive outlook, could quickly reverse the current trend and push the emerging markets index towards the highs seen in 2007 and 2011, or even higher. It is difficult to expect returns in excess of 50% from the S&P 500, while it is a possibility with emerging markets, but larger losses are also possible.

Conclusion

Investors do not like emerging markets at the moment, so if you have the guts to buy something others dislike and fight the trend, you might be rewarded with extraordinary returns or extraordinary losses. Fortunately, markets do not just obey investors’ sentiment, but also have fundamentals and fundamentals are on the emerging markets side.

As there is a possibility of further declines for emerging markets, a good strategy is to have a proportional weighted exposure to them. By always keeping the same percentage of your portfolio in emerging markets, you get the nice dividend yield, trim your position when markets go up and buy more when markets are cheaper. ETFs give the best opportunities to follow such a strategy.

 

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A Broader Perspective on the Global Economy


  • Easing monetary policies go on globally but do not seem to fuel sustainable growth.
  • China is slowing, Japan is looking toward another recession, and the global outlook is adjusted downwards.
  • Bad news might be around the corner, but good news is as well.

Introduction

News is usually focused on the latest happenings. The fact that the human brain is set up in a way that it always tries to focus and eliminate marginal information brings to the consequence that most people do not objectively analyze the world around them. An example: How many blue cars have you seen today? Probably none because you were not looking for them, but as soon as you focus on them you will be surprised by how many you will see. The same applies to finance.

Just two and a half months ago the S&P 500 was 12.5% lower than now and headlines were filled with negative scenarios. Oil prices were below $30 and investors looked to avoid any kind of risk by selling stocks and buying bonds. Then, on February 11, FED Chairwoman Yellen hinted to Congress that “the central bank had increased trepidation over the path of interest-rate increases, pointing to accumulating risks to the economy in recent weeks.” The market focused on prolonged low interest rates and not on the accumulating risks in the economy. This article is going to give a broader perspective on the current state of the global economy in relation to financial markets by taking a look at the situation in the strongest economies.

The US

The main economic indicator, albeit one that shows only what has happened, is the Gross Domestic Product (GDP).

Figure 1: US GDP estimates and actual. Source: The Wall Street Journal – Economic Forecast.

The Wall Street Journal has surveyed 60 economists and their estimations are positive and project stable growth of more than 2%. As shown in the figure above, the previous estimates (red line) are usually stable and positive, while actual results (grey columns) are much more volatile and with negative surprises.

There is a rule in finance where if you are wrong with your estimation alongside others the collective wrongness saves you, but if you are wrong and your opinion is far from consensus, your career is at risk. Unfortunately, this usually brings stable, similar estimates close to each other and big actual surprises.

A more scientific way of estimating GDP is done by the Federal Reserve Bank of Atlanta with GDPNow, as it uses only econometrical models based on economic data variables. Figure 2 shows how this metric diverges from the general consensus above.

Figure 2: Atlanta FED GDPNow forecast. Source: Federal Reserve Bank of Atlanta – GDPNow.

The GDPnow model is forecasting only 0.3% growth for Q1 2016. The first advanced estimate from the Bureau of Economic Analysis (BEA) for the first quarter 2016 is due on the 28th of April and will show who is correct, in any case it could be market moving news.

Japan

Japan is still finding it tough to reach stable economic growth. “Abenomics,” the monetary easing policy implemented by Japan’s prime minister Shinzo Abe in 2012, is failing to produce the expected results. If Japan experiences another quarter without growth it will be just another recession that has plagued Japan’s economy in the last two decades.

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Figure 3: Japan’s GDP growth. Source: Trading Economics.

A recession in Japan should not make a big influence in international markets as it is generally expected that Japan stagnates, but both the incapacity of creating economic growth—even with a negative 0.1% interest rate—and the aging population strongly resembles the situation in Europe.

Europe

The Eurostat will publish preliminary flash estimates of quarterly GDP for the EU area on the 29th of April, synchronizing publications with the BEA (usually 15 days later). This is another piece of information that will be interesting for markets.

Estimates from the European Commission are that the EU area will grow by 1.9% in 2016, but the European Central Bank’s (ECB) decisions do not support such a positive forecast. Last week ECB president, Mario Draghi, left the current low interest rate and market purchases policy unchanged and hinted towards further easing in order to bring the EU economy to the expected levels. Almost two years of interest rates close to zero and the ECB purchasing even corporate bonds did not yet push the EU economy towards the hoped levels, an indication that strong growth for the EU might be difficult to reach. Also, Markit’s Composite Flash Purchasing Managers’ Index is showing signs of slowing growth, falling to 13 month lows in March 2016 for the EU.

Other political issues threaten European growth in 2016. The UK will vote on whether to remain in the EU in June and the pre vote polls do not indicate a clear winner. The UK leaving the EU would have significant economic repercussions and increase the political uncertainty that would strongly influence the Euro and the markets. The immigrant crisis from the Middle East is still a concern and possible increases in border controls might further slow economic trade.

Apart from the negative view, there is always hope that the easing policies will work, the weak Euro promotes exports, the UK might vote to stay in the EU, and immigration might help improve the negative demographics in Europe.

China and Emerging Markets

A fact that was soon forgotten is that the Chinese economic growth in the last few quarters was the slowest in the last 25 years.

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Figure 4: Chinese economic growth from 2010 to 2016. Source: Trading Economics.

China is still growing but many expectations and models that were based on higher growth rates have to be amended. The economic slowdown did induce the huge drop in commodity values in 2015 and that effect will surely reflect itself in local and global economic measures.

China sneezes and emerging markets get a cold. The largest economic downward adjustments are seen in emerging markets, of which Brazil and Russia are the most pronounced. The International Monetary Fund (IMF) expects that the prolonged slump in commodity prices will have a severe impact on emerging markets as they base their economies on exports of primary goods. Africa’s growth is expected to be around 3.7%, thus far from the usual high single digits.

Conclusion

A quick look at what is going on globally does not give much inspiration. The news did not change much since February except that central banks are going to continue with quantitative easing that gave relief to markets. But, the outlook is much bleaker than it was a year ago and the low commodity prices do not contribute to a global increase in economic activity. The IMF predicted in its February outlook that global growth in 2016 would be only 2.5%, which is 35% lower than the average of 3.8% for the last 6 years.

Even if the above data might be a little bit pessimistic, to brighten up the article, China, Africa, the US and Europe are all still growing, albeit at a slower pace so severe economic crises are not expected. But negative news may be just around the corner, so investors should be careful when assessing their risks.